The Basic Equation of Accounting

- The basic equation of accounting states: "What you have minus what you owe is what you're worth."

Assets - Liabilities = Worth

"have" "owe" "value to owners"

- Worth, net worth, equity, owners' equityand shareholders' equityall mean the same thing - the value of the enterprise belonging to its owners.

- The Balance Sheet presents the basic equation of accounting in a slightly rearranged form:

Assets = Liabilities + Worth

"have" "owe" "value to owners"

- By definition, this equation is always "in balance" with assets equaling the sum of liabilities and worth.

So, if you add an asset to the left side of the equation, you must also increase the right side by adding a liability or increasing worth. Two entries are required to keep the equation in balance.

(b) The Balance Sheet - a snapshot in time.

- The Balance Sheet presents the financial picture of the enterprise on one particular day, an instant in time, the date it was written.

- The Balance Sheet presents:

what the enterprise has today: assets

how much the enterprise owes today: liabilities

what the enterprise is worth today: equity

- The Balance Sheet reports:

Has today = Owes today + Worth today

assets liabilities shareholders^' equity

(c) What are Assets?

- Assets are everything you've got - cash in the bank, inventory, machines, buildings…

- Assets are also certain "rights" you own that have a monetary value...like the right to collect cash from customers who owe you money.

- Assets are valuable and this value must be quantifiable for an asset to be listed on the Balance Sheet. Everything in a company's financial statements must be translated into dollars and cents (or pounds and pence).

(d) Grouping Assets for Presentation

- Assets are grouped for presentation on the Balance Sheet according to their characteristics:

very liquid assets cash and securities

productive assets plant and machinery

assets for sale inventory

- Accounts receivable are a special type of asset group: the obligations of customers of a company to pay the company for goods shipped to them on credit.

- Assets are displayed in the asset section of the Balance Sheet in the descending order of liquidity (the ease of convertibility into cash). Cash itself is the most liquid of all assets; fixed assets are normally the least liquid.

(e) What are Liabilities?

- Liabilities are economic obligations of the enterprise such as money that the corporation owes to lenders, suppliers, employees, etc.

- Liabilities are categorized and grouped for presentation on the balance sheet by:

(1) to whom the debt is owed and

(2) whether the debt is payable within the year (current liabilities) or is a long-term obligation.

- Shareholders' equity is a very special kind of liability. It represents the value of the corporation that belongs to its owners. However, this "debt" will never be repaid in the normal course of business.

B. - The Balance Sheet in TheUS

(a) Prescribed format

BALANCE SHEET FORMAT

as of a specific date

ASSETS LIABILITIES &EQUITY

CASH ACCOUNTS PAYABLE

ACCOUNTS RECEIVABLE ACCRUED EXPENSES

INVENTORY CURRENT PORTION OF DEBT

PREPAID EXPENSES INCOME TAXES PAYABLE

CURRENT ASSETS CURRENT LIABILITIES

OTHER ASSETS LONG-TERM DEBT

FIXED ASSETS AT COST CAPITAL STOCK

ACCUMULATED DEPRECIATION RETAINED EARNINGS

NET FIXED ASSETS SHAREHOLDERS^' EQUITY

TOTAL ASSETS TOTAL LIABILITIES & EQUITY

Single lines on a financial statement indicate that a calculation (addition or subtraction) has been made on the numbers just preceding in the column.

Theuse of a double underline signifies the very last figure in the statement.

(b) Current Assets

- By definition, current assets are those assets that are expected to be converted into cash in less than 12 months.

- Current asset groupings are listed in order of liquidity with the most easy to convert into cash listed first:

1. Cash

2. Accounts receivable

3. Inventory

- The money the company will use to pay its bills in the near term (within the year) will come when itscurrent assets are converted into cash (that is, inventory is sold and accounts receivable are paid).

(c) Current Assets: Cash

- Cash is the ultimate liquid asset: on-demand deposits in a bank as well as the dollars and cents in the petty cash drawer.

- When you write a check to pay a bill you are taking money out of cash assets.

- Like all the rest of the Balance Sheet, cash is denominated in U.S. dollars for corporations in the United States. A U.S. company with foreign subsidiaries would convert the value of any foreign currency it holds (and also other foreign assets) into dollars for financial reporting.

(e) Current Assets: Accounts Receivable

- When the enterprise ships a product to a customer on credit, the enterprise acquires a right to collect money from that customer at a specified time in the future.

- These collection rights are totaled and reported on the Balance Sheet as accounts receivable.

- Accounts receivable are owed to the enterprise from customers (called "accounts") who were shipped goods but have not yet paid for them. Credit customers - most business between companies is done on credit - are commonly given payment terms that allow 30 or 60 days to pay.

(f) Current Assets: Inventory

• Inventory is both finished products for ready sale to customers and also materials to be made into products. A manufacturer's inventory includes three groupings:

1. Raw material inventory is unprocessed materials that will be used in manufacturing products.

2. Work-in-process inventory is partially finished products in the process of being manufactured.

3. Finished goods inventory is completed productsready for shipment to customers when they place orders.

• As finished goodsinventory issold it becomes an accounts receivable and then cashwhen the customer pays.

(g) Current Assets: Prepaid Expenses

- Prepaid expenses are bills the company has already paidbut for services not yet received.

- Prepaid expenses are things like prepaid insurance premiums, prepayment of rent, deposits paid to the telephone company, salary advances, etc.

- Prepaid expenses are current assets not because they can be turned into cash, but because the enterprise will not have to use cash to pay them in the near future. They have been paid already.

(h) Current Asset Cycle

- Current assets are said to be "working assets" because they are in a constant cycle of being converted into cash. The repeating current asset cycle of a business is shown below:

cashbuys inventory

inventorywhen sold

becomesaccounts receivable

accounts receivableupon

collection becomes cash

(i) More asset types

- In addition to a company's current assets, there are two other major asset groups listed on the Balance Sheet: Other assets and fixed assets. These so-called "non-current assets" are not converted into cash during the normal course of business.

- Other assets is a catchall category that includes intangible assets such as the value of patents, trade names and so forth.

- The company's fixed assets (so-called property, plant and equipment or PP&E) is generally the largest and most important non-current asset grouping.

(j) Fixed Assets

- Fixed assets are productive assets not intended for sale. They will be used over and over again to manufacture the product, display it, warehouse it, transport it and so forth.

- Fixed assets commonly include land, buildings, machinery, equipment, furniture, automobiles, trucks, etc.

- Fixed assets are normally reported on the Balance Sheet as net fixed assets - valued at original costminusan allowance for depreciation.

(k) Depreciation

- Depreciation is an accounting convention reporting (on the Income Statement) the decline in useful value of a fixed asset due to wear and tear from use and the passage of time.

- Depreciating an asset means spreading the cost to acquire the asset over the asset's whole useful life.

- Accumulated depreciation (on the Balance Sheet) isthe sum of all the depreciation charges taken since the asset was first acquired.

- Depreciation charges taken in a period do lowerprofitsfor the period, but do not lowercash. Cash was required to purchase the fixed asset originally.

(l) Net Fixed Assets

- The net fixed assets of a company are the sum of its fixed assets' purchase prices("fixed assets @ cost") minus the depreciation charges taken on the Income Statement over the years ("accumulated depreciation").

- The so-called book valueof an asset - its value as reported on the books of the company - is the asset's purchase price minus its accumulated depreciation.

- Note that depreciation does not necessarily relate to an actual decrease in value. In fact, some assets appreciate in value over time. However, such appreciated assets are by convention still reported on the Balance Sheet at their lower book value.

(m) Other Assets

- The other asset category on the Balance Sheet includes assets of the enterprise that cannot be properly classified into current asset or fixed asset categories.

- Intangible assets(a major type of other assets) are things owned by the company that have value but are not tangible (that is, not physical property)in nature.

For example, a patent, a copyright, or a brand name can have considerable value to the enterprise, yet these are nottangiblelike a machine or inventory is.

- Intangible assetsare valued by management according to various accounting conventions usually very complex, arbitrary and confusing (not for us to delve into).

(n) Current Liabilities

- Current liabilities are bills that must be paid within one yearofthe date ofthe Balance Sheet. Current liabilities are a reverse of current assets:

currentassets...provide cash within 12 months

currentliabilities...take cash within 12 months.

- The cash generated from current assets is used to pay current liabilities as they become due.

- Current liabilities are grouped depending on to whom the debt is owed:

(1) accounts payable owed to suppliers,

(2) accrued expenses owed to employees and others for services,

(3) current debt owed to lenders

(4) taxesowed to the government.

(o) Current Liabilities: Accounts Payable

- Accounts payable are bills, generally to other companies for materials and equipment bought on credit, that the corporation must pay soon.

- When it receives materials, the corporation can either pay for them immediately with cash or wait and let what is owed become an account payable.

- Business-to-business transactions are most often done on credit. Common trade payment terms are usually 30 or 60 days with a discount for early payment like 2% off if paid within 10 days, or the total due in 30 days (^"2% 10; net 30^").

(p) Current Liabilities: Accrued Expenses

- Accrued expenses are monetary obligations similar to accounts payable. The business uses one or the other classificationdepending on to whom the debt is owed.

- Accounts payable is used for debts to regular suppliers of merchandise or services bought on credit.

- Examples of accrued expenses are salaries earned by employees but not yet paid to them; lawyers' bills not yet paid; interest due but not yet paid on bank debt and so forth.

(q) Current Debt and Long Term Debt

- Any notes payable and the current portion of long-term debt are both components of current liabilities and are listed on the Balance Sheet under current portion of debt.

- If the enterprise owes money to a bank and the terms of the loan say it must be repaid in less than 12 months, then the debt is called a note payable and is a current liability.

- A loan with an overall term of more than 12 months from the date of the Balance Sheet is called long-term debt. A mortgage on a building is a common example.

The so-called current portion of long-term debt is that amount due for payment within 12 months and is a current liability listed under current portion of debt.

(r) Current Liabilities: Taxes Payable

- Every time the company sells something and makes a profit on the sale, a percentage of the profit will be owed the government as income taxes.

- Income taxes payable are income taxes that the company owes the government but that the company has not yet paid.

- Every three months or so the company will send the government a check for the income taxes owed. For the time between when the profit was made and the time that the taxes are actually paid, the company will show the amount to be paid as income taxes payable on the Balance Sheet.

(s) Working Capital

- The company's working capital is the amount of money left over after you subtract current liabilities from current assets.

Current Assets - Current Liabilities = Working Capital

Cash Accounts Payable

Accounts Receivable Accrued Expenses

Inventory Current Debt

Prepaid Expenses Taxes Payable

- Working capital is the amount of money the enterprise has to "work with" in the short-term.

- Working capital feeds the operations of the enterprise with dollar bills.

- Working capital is also called "net current assets" or simply "funds."

(t) Sources and Uses of Working Capital

- Sources of working capital are ways working capital increases in the normal course of business. This increase in working capital happens when:

1. current liabilities decrease and/or

2. current assets increase

- Uses of working capital (also called applications) are ways working capital decreases during the normal course of business. For example when:

1. current assets decrease and/or

2. current liabilities increase

- With lots of working capital it will be easy to pay your "current" financial obligationsthat come due in the next 12 months.

(u) Total Liabilities

- A company's total liabilities are just the sum of its current liabilitiesand its long-term debt.

- Long-term debt isany loan to the company to be repaid more than 12 months after the date of the Balance Sheet.

- Common types of long-term debt include mortgages for land and buildings and so-called chattel mortgages for machinery and equipment.

- There is not a separate line for total liabilities in most Balance Sheet formats.

(v) Shareholders' Equity

- If you subtract what the company owes (Total Liabilities) from what it has (Total Assets) you are left with companies value to its owners...its shareholders' equity.

- Shareholders' equity has two components:

1. Capital Stock. The original amount of money the owners contributed as their investment in the stock of the company.

2. Retained Earnings. All the earnings of the company that have been retained, that is, not paid out as dividends to owners.

- Note: Both "net worth" and "book value" mean the same thing as shareholders' equity.

(w) Capital Stock

- The original money to start and any add-on money invested in the business is represented by shares of capital stock held by owners of the enterprise.

- So-called common stockisthe regular "denomination of ownership" for all corporations. All companies issue common stock, but they may issue other kinds of stock, too.

- Companies often issue preferred stockthat have certain contractual rights or "preferences" over the common stock. These rights may include a specified dividend and/or a preference over common stock to receive company assets if the company is liquidated.

(x) Retained Earnings

- All of the company's profits that have not been returned to the shareholders as dividends are called retained earnings.

retained earnings = sum of all profits - sum of all dividends

- Retained earnings can be viewed as a "pool" of money from which future dividends could be paid. In fact, dividends cannot be paid to shareholders unless sufficient retained earnings are on the Balance Sheet to cover the total amount of the dividend checks.

- If the company has not made a profit but rather has sustained losses, it has "negative retained earnings" that are called its accumulated deficit.

(y) Changes in Shareholders' Equity

- Shareholders' equity is just the sum of the investment made in the stock of the company plus any profits (less any losses)minus any dividends that have been paid to shareholders.

- The value of shareholders' equity increases when the company:

(1) makes a profit, thereby increasing retained earnings, or

(2) sells new stock to investors, thereby increasing capital stock.

- The value of shareholders' equity decreases when the company:

(1)has a loss, thereby lowering retained earnings, or

(2)pays dividends to shareholders, thereby lowering retained earnings.

Date: 2015-01-29; view: 734